New Definition of Accredited Investor: VC Funds Not Included

Joseph W. Bartlett, Special Counsel, McCarter & English, LLP

The Commission was obviously frustrated by the Court of Appeals
decision in Goldstein, which vacated its rule intended to
regulate hedge funds as Investment Advisers under the 1940 Act. The
Commission continues to feel that the investing public needs
protection. Therefore, a laundry list of proposals is likely to
emanate from the Staff, the first being Release No. 33-8766 (Dec.
13, 2006). The Release proposes that, in view of inflation since the
"accredited investor" standard for natural persons was adopted in
1982, Rules 509 and 216 should be amended to upgrade the definition
of "accredited investor" for purposes of the sale of securities by
a private equity funds (which the Commission refers to as "Private
Investment Pools") in reliance on Reg. D, [1] increasing the net worth test to $2.5
million in investment assets from $1 million in net worth, the
current net worth test in Rule 501(a) [2] The proposal
goes half way towards the $5 million test in 3(c)(7) of the
Investment Company Act of 1940, for Qualified Purchasers.Personal
residence is not considered an investment for this purpose, of
course.

The surprisingly novel aspect of the proposed rule is that it
would not apply to venture capital funds, as defined in Section
202(a)(22) of the Investment Advisers Act. the definition of
Business Development Company. For venture capital funds, this will
bring back a number of funds which had thought they had escaped the
"significant participation" test under ERISA, and the concommitant
requirement to exempt themselves as Venture Capital Operating
Companies . when the 2006 Pension Protection Act took out of
the equation investments by state and municipal pension funds and
offshore funds . i.e., not otherwise subject to
ERISA. By borrowing a definition from the Business Development
Company amendments in 1980 to the Investment Company Act, the
Commission reintroduces the idea of managerial assistance by the
fund in order to qualify itself for exempt status . in this
case incorporating the notion that, to take advantage of the old
(i.e., amended) accredited investor definition, the
venture fund (vide the Business Development Company) must offer
managerial assistance to 60% (vs. 70% in the Investment Company
Act) of its portfolio.See Release No. 33-876, fn 69.

There are additional bells and whistles, as described in a
recent Shearman & Sterling memorandum. [3]

"The proposal does not grandfather
natural persons who currently hold investments as accredited
investors. If such an investor wishes to make future investments in
private investment vehicles, even in vehicles in which such
investor currently holds securities, it appears the investor will
have to satisfy the new $2,500,000 threshold for accredited natural
persons.

"The proposed rules also do not
address whether employees of pooled investment vehicles or their
managers must satisfy the new criteria for accredited natural
persons. This is notwithstanding the fact that many private
investment vehicles currently offer their securities to such
employees who do not meet the accredited investor criteria. In the
Release, the SEC recognized that these investments can currently be
made, without requiring employees t be accredited natural persons,
in one of four ways: (1) in reliance on Rule 506, which allows,
with certain requirements, up to 35 non-accredited purchasers; (2)
in an offering pursuant to Section 4(2) of the Securities Act; (3)
in reliance on Rule 701 under the Securities Act, which provides a
registration exemption for offers and sales of securities to
certain natural persons pursuant to certain compensation
arrangements; or (4) pursuant to employment contracts that are not
directly subject to federal securities regulation. These four
exceptions from the accredited investor standard remain
undisturbed."

[2] And
Rule 215, which applies to offerings which are exempt under Section
4(6), versus 4(2), of the `33 Act, applying to small issuers
offering no more than $5 million of securities and not engaging in
general solicitation). See "SEC Proposes New Rules" Shearman &
Sterling Client Publication (Jan. 22, 2007).

"An investor
who invests in a private investment vehicle solely on his or her
own behalf may include only 50% of any investments held jointly
with a spouse. If the investment in the private investment vehicle
is made jointly with a spouse, alljoint investments may be counted
toward the threshold. Any real estate that is not held for
investment purposes is excluded from the calculations. This
includes real estate used for personal purposes or as a place of
business or held in connection with a trade or business.
Investments would be valued based on their fair market value on a
per-investment basis, meaning a new valuation of even highly
illiquid investments is required at the time of each new investment
in a 3(c)(1) issuer."

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